Beating the market through behavioral finance.

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TomCat96
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Beating the market through behavioral finance.

Post by TomCat96 » Tue Feb 14, 2017 4:48 pm

Is there a reason why staying the course is hard?

Should we assume the vast majority of people are capable of handling 40% drops in the market? Or should we assume that we should advise them based on such characteristics being uncommon.

If the ability to stay the course is difficult, would that not theoretically open up an avenue for hedge funds to exploit?
For example if markets go up, then the intrinsic greed of people might cause people to jump in. If markets go down, then the intrinsic attribute of people to panic would cause even more people to sell.

If such tendencies were exploitable, it seems that one could profit without any special market information at all.
One would be able to outperform the market because of the market inefficiency caused by human nature.

A fund which operates as such would be able to profit not because of superior information, but because of superior ability to execute based on the same static information. Are human tendencies exploitable in investing?

Sachay
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Re: Beating the market through behavioral finance.

Post by Sachay » Tue Feb 14, 2017 4:55 pm

Hedge funds are run by people. Hedge funds returned only 23 percent from 2010 to 2015, compared with 108 percent for the S&P Index. I exploited this in the best way possible- by hardly lifting a finger. Too bad us mere mortals can't short the hedge funds or receive million dollar bonuses for subpar performance.

TomCat96
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Re: Beating the market through behavioral finance.

Post by TomCat96 » Tue Feb 14, 2017 5:03 pm

Sachay wrote:Hedge funds are run by people. Hedge funds returned only 23 percent from 2010 to 2015, compared with 108 percent for the S&P Index. I exploited this in the best way possible- by hardly lifting a finger. Too bad us mere mortals can't short the hedge funds or receive million dollar bonuses for subpar performance.

I didn't mean hedge funds per se, I meant strategically if there is a tendency for people to trade based on human factors, such factors ought to theoretically be exploitable by anyone with sufficient capital and liquidity.
Last edited by TomCat96 on Tue Feb 14, 2017 5:40 pm, edited 1 time in total.

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patrick013
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Re: Beating the market through behavioral finance.

Post by patrick013 » Tue Feb 14, 2017 5:19 pm

TomCat96 wrote:Is there a reason why staying the course is hard?
Because people don't know they should. Then it's easy.
It's in the Boglehead book. Once that becomes known then
Tax Loss Harvesting, buying a put option for certain stock
funds, can also be done. Saying some other party can exploit
that, don't know, or even if they'd want to do something else.
age in bonds, buy-and-hold, 10 year business cycle

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Re: Beating the market through behavioral finance.

Post by Fallible » Tue Feb 14, 2017 5:28 pm

TomCat96 wrote:
Sachay wrote:Hedge funds are run by people. Hedge funds returned only 23 percent from 2010 to 2015, compared with 108 percent for the S&P Index. I exploited this in the best way possible- by hardly lifting a finger. Too bad us mere mortals can't short the hedge funds or receive million dollar bonuses for subpar performance.

I didn't mean hedge funds per se, I meant strategically if there is a tendency for people to trade based on human factors, such factors ought to theoretically be exploitable by anyone with sufficient and liquidity.
I think you are missing a key word after "sufficient."
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TomCat96
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Re: Beating the market through behavioral finance.

Post by TomCat96 » Tue Feb 14, 2017 5:40 pm

Fallible wrote:
TomCat96 wrote:
Sachay wrote:Hedge funds are run by people. Hedge funds returned only 23 percent from 2010 to 2015, compared with 108 percent for the S&P Index. I exploited this in the best way possible- by hardly lifting a finger. Too bad us mere mortals can't short the hedge funds or receive million dollar bonuses for subpar performance.

I didn't mean hedge funds per se, I meant strategically if there is a tendency for people to trade based on human factors, such factors ought to theoretically be exploitable by anyone with sufficient and liquidity.
I think you are missing a key word after "sufficient."
ah yes. where is my brain these days?
fixed. sufficient capital and liquidity.

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Toons
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Re: Beating the market through behavioral finance.

Post by Toons » Tue Feb 14, 2017 5:43 pm

"Is there a reason why staying the course is hard?"

Too much day to day noise in the background.
Derails the best laid investment plans of mice and men :happy
Last edited by Toons on Tue Feb 14, 2017 5:43 pm, edited 1 time in total.
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livesoft
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Re: Beating the market through behavioral finance.

Post by livesoft » Tue Feb 14, 2017 5:43 pm

Some things are not scaleable. Hedge funds have to use something that is scaleable and can be done with large amounts of money. What I do with a million dollars can be taken care of with a few ETF trades. I definitely use behavioral finance or as I like to call it: other people's "peace of mind" and "mental accounting" to make money.

Also I don't try to beat the market. Instead, I try to beat a benchmark. Big difference.
Last edited by livesoft on Tue Feb 14, 2017 5:45 pm, edited 1 time in total.
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TomCat96
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Re: Beating the market through behavioral finance.

Post by TomCat96 » Tue Feb 14, 2017 5:44 pm

patrick013 wrote:
TomCat96 wrote:Is there a reason why staying the course is hard?
Because people don't know they should. Then it's easy.
It's in the Boglehead book. Once that becomes known then
Tax Loss Harvesting, buying a put option for certain stock
funds, can also be done. Saying some other party can exploit
that, don't know, or even if they'd want to do something else.
My impression was that staying the course is hard not because one doesn't know to stay the course, but that people are emotionally driven creatures unable to bear the weight of a market crash to their resolve.

Perhaps that impression is incorrect?

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Aptenodytes
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Re: Beating the market through behavioral finance.

Post by Aptenodytes » Tue Feb 14, 2017 5:49 pm

I hope you like reading lots of quotes from smart people, because within minutes Taylor Larimore will send you about 50. They will tell you that although it is true that you can count on many people making consistent mistakes regarding market timing, the only way to outperform those mistake-makers is not to play their game better, but not to play their game at all.

The following two strategies both benefit from the mistakes that people make buying high and selling low, and enable you to avoid them:

1) be a buy/hold/rebalance investor. This is the way that Taylor believes in, and all his quotes will support it, and they are all irrefutable. The reason: you may be smarter than all of the mistake-makers, but you aren't smart enough to know when the mistake-makers in aggregate are generating a trough or a peak. So you'll be forced to engage in the same kind of superstition and wishful thinking as the mistake-makers, and therefore you lose the game.

2) be a value investor. Taylor's quotes won't lead you in this direction, but it is a proven way to profit off the vagaries of the market. If you tilt toward equities with low price-to-equity ratios, e.g. through a value index fund, you will get a couple extra percentage points in your expected long-term return. Warren Buffett credits this strategy, which he learned from Benjamin Graham, with making him a billionaire. He took far more risk than anyone would counsel you to take, investing in individual stocks, but the core idea is the same and if followed consistently will probably make you extra money (nobody can know if the future will be like the past in this regard). Value investing works not strictly because of people buying high and selling low, but that error helps.

Nothing else will enable you to profit off the mistakes you mention, I don't believe.

Note that if you opt for (2) over (1) then you are in the world of factors, and you logically should construct a portfolio taking into account all relevant knowledge about factors, and then you discover that small-value has greater expected return than value, and you are essentially off the reservation you entered.

bigred77
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Re: Beating the market through behavioral finance.

Post by bigred77 » Tue Feb 14, 2017 5:58 pm

TomCat96 wrote:
If the ability to stay the course is difficult, would that not theoretically open up an avenue for hedge funds to exploit?
For example if markets go up, then the intrinsic greed of people might cause people to jump in. If markets go down, then the intrinsic attribute of people to panic would cause even more people to sell.
Although I'm not sure if academics attribute this to behavioral finance or "greed and panic", I think you've pretty much described the often discussed momentum factor. Some people say "the trend is your friend".

I'm not all that knowledgeable or confident in factors outside of value and size, but you might be interested in learning more about the momentum factor if this interests you.

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patrick013
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Re: Beating the market through behavioral finance.

Post by patrick013 » Tue Feb 14, 2017 5:59 pm

TomCat96 wrote:
patrick013 wrote:
TomCat96 wrote:Is there a reason why staying the course is hard?
Because people don't know they should. Then it's easy.
It's in the Boglehead book. Once that becomes known then
Tax Loss Harvesting, buying a put option for certain stock
funds, can also be done. Saying some other party can exploit
that, don't know, or even if they'd want to do something else.
My impression was that staying the course is hard not because one doesn't know to stay the course, but that people are emotionally driven creatures unable to bear the weight of a market crash to their resolve.

Perhaps that impression is incorrect?
Well the main thing is knowing not to sell and walk away
with a permanent loss. The last crash was an example of
that. Can't get rid of all risk but that's a big mistake.
age in bonds, buy-and-hold, 10 year business cycle

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David Jay
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Re: Beating the market through behavioral finance.

Post by David Jay » Tue Feb 14, 2017 6:50 pm

TomCat96 wrote:
Sachay wrote:Hedge funds are run by people. Hedge funds returned only 23 percent from 2010 to 2015, compared with 108 percent for the S&P Index. I exploited this in the best way possible- by hardly lifting a finger. Too bad us mere mortals can't short the hedge funds or receive million dollar bonuses for subpar performance.

I didn't mean hedge funds per se, I meant strategically if there is a tendency for people to trade based on human factors, such factors ought to theoretically be exploitable by anyone with sufficient capital and liquidity.
Band-based rebalancing is the way to exploit this. Ask around - how many here in BH were actively rebalancing INTO stocks at the bottom of the financial crisis. It is HARD to buy when the bottom really drops out of the market.

If the OP didn't have a few hundred thou in stocks in 2008, he can't appreciate how hard it is to "stay the course" when the nightly news is talking total collapse of the financial system.
Last edited by David Jay on Wed Feb 15, 2017 10:22 am, edited 1 time in total.
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TomCat96
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Re: Beating the market through behavioral finance.

Post by TomCat96 » Tue Feb 14, 2017 6:57 pm

bigred77 wrote:
TomCat96 wrote:
If the ability to stay the course is difficult, would that not theoretically open up an avenue for hedge funds to exploit?
For example if markets go up, then the intrinsic greed of people might cause people to jump in. If markets go down, then the intrinsic attribute of people to panic would cause even more people to sell.
Although I'm not sure if academics attribute this to behavioral finance or "greed and panic", I think you've pretty much described the often discussed momentum factor. Some people say "the trend is your friend".

I'm not all that knowledgeable or confident in factors outside of value and size, but you might be interested in learning more about the momentum factor if this interests you.
fwiw, one thing I do everyday is check the S&P 500 futures market. I'm interested in seeing what the speculators think.
Right now if their forum is any indication of their sentiment, the vast majority of them have been completely demolished these past few months because they keep shorting the market. In fact the higher the market has gotten recently, the stronger their resolve to short has been, in spite of losses.

All these shorts become eventual contributors to the trend ironically. As the markets go up, their shorts get squeezed, and they're forced to buy into the market they bet against in order to cut their losses.

I strongly doubt markets are going up with these bearish speculators in mind. But from a behavioral perspective, the recent uptrend has completely profited off their backs. I say behavioral because such profit has nothing to do with stock earnings/reports.

While going up, the market just so happened to trash a bunch of short speculators in the process, fueling the recent trend in excess of earnings reports. I'm sure their contribution was insignificant, but it was also non-zero.

TomCat96
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Re: Beating the market through behavioral finance.

Post by TomCat96 » Tue Feb 14, 2017 7:05 pm

David Jay wrote:
TomCat96 wrote:
Sachay wrote:Hedge funds are run by people. Hedge funds returned only 23 percent from 2010 to 2015, compared with 108 percent for the S&P Index. I exploited this in the best way possible- by hardly lifting a finger. Too bad us mere mortals can't short the hedge funds or receive million dollar bonuses for subpar performance.

I didn't mean hedge funds per se, I meant strategically if there is a tendency for people to trade based on human factors, such factors ought to theoretically be exploitable by anyone with sufficient capital and liquidity.
Rebalancing is the way to exploit this. Ask around - how many here in BH were actively rebalancing INTO stocks at the bottom of the financial crisis.

If the OP didn't have a few hundred thou in stocks in 2008, he can't appreciate how hard it is to "stay the course" when the nightly news is talking total collapse of the financial system.

That's a good point. Rebalancing inherently would exploit aberrations in the market due to human behavior. In that same rationale, staying the course would make one immune to behavioral finance exploitation.

A behavioral finance strategy cannot profit off one who is resolved to stay the course no matter what.

As for the 2008 crisis, I'll honestly never know. I can't even speculate what I would have done. I was in grad school at the time and completely cashed out my 401k in late 2007 to pay for grad school.

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Re: Beating the market through behavioral finance.

Post by toto238 » Tue Feb 14, 2017 7:10 pm

patrick013 wrote:
TomCat96 wrote:
patrick013 wrote:
TomCat96 wrote:Is there a reason why staying the course is hard?
Because people don't know they should. Then it's easy.
It's in the Boglehead book. Once that becomes known then
Tax Loss Harvesting, buying a put option for certain stock
funds, can also be done. Saying some other party can exploit
that, don't know, or even if they'd want to do something else.
My impression was that staying the course is hard not because one doesn't know to stay the course, but that people are emotionally driven creatures unable to bear the weight of a market crash to their resolve.

Perhaps that impression is incorrect?
Well the main thing is knowing not to sell and walk away
with a permanent loss. The last crash was an example of
that. Can't get rid of all risk but that's a big mistake.
It's important to note that the "don't take a loss" philosophy is only correct if the underlying strategy was sound and will eventually pay off. If you were invested in a non-diversified, volatile asset that has taken a major hit, "taking the loss" could very well be the best course forward. It's one thing to make the bet that the stock market as a whole will eventually recover. It's another to bet that stock XYZ will recover faster and stronger than the market as a whole.

I see people make this mistake most often with real estate, specifically primary residences. People feel a sense of "loss aversion" and therefore refuse to sell their house for less than they bought it for. The house is in a dead real estate market that isn't likely to recover anytime soon as the largest employers in the area have moved their operations to other states and/or countries. They give up job opportunities that would require them to move and help them get out of the rut that they're in. They aren't underwater on the house, so they could sell it, but they just can't bring themselves to do it until it recovers 20-40% to get back to where it was when they bought it. They would've been better off cutting their losses.

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Re: Beating the market through behavioral finance.

Post by arcticpineapplecorp. » Tue Feb 14, 2017 7:26 pm

TomCat96 wrote:Is there a reason why staying the course is hard?

Should we assume the vast majority of people are capable of handling 40% drops in the market? Or should we assume that we should advise them based on such characteristics being uncommon.

A fund which operates as such would be able to profit not because of superior information, but because of superior ability to execute based on the same static information. Are human tendencies exploitable in investing?
Did you mean to say "should we assume the vast majority of people are INCAPABLE of handling 40% drops in the market"? Because that's what I've come to believe. I don't think there are many who can handle that. And it's not just because of fear (though that is a large reason). I witnessed a 45 year old woman sell all her low cost index stock funds and move money to a stable value fund AFTER the market declined in 2008 despite having at least 20 years until retirement, a recession resistent job (became busier during the recession because of a increase in applicants for benefits), a four-year government contract and the backing of a union. And yet she still sold it all (at the wrong time). And the U.S. market didn't even lose 40% in 2008 (it lost 38% if memory serves. Yes I know that's basically the same thing).

But let us not forget there were many people who had investments in 2008-2009 and had done everything they were told to do prior, as in "keep an emergency fund of 3-6 months" which was conventional wisdom prior to the Great Recession, and only after that were experts telling people to keep a year or more in emergency savings (that would have been helpful before the recession, not after). These fine folks did everything right, but they were out of a job and couldn't get another one for a year or longer. These folks had to raise cash any way they could which meant selling stocks. They may not had wanted to, but they had to in order to keep food on table, roof over head and gas in car.

Finally, regarding your second statement above (about a fund that operates), let's not forget that funds have to meet redemptions. Less redemptions if people don't panic, but in the example I gave above regarding people having to sell out whether they wanted to or not, this resulted in many funds being forced to sell also, whether they wanted to or not. So fund managers aren't at their own whims. They have to work within the limitations they're given, which includes fund outflows, sometimes at the worst possible times.
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Re: Beating the market through behavioral finance.

Post by pkcrafter » Tue Feb 14, 2017 7:49 pm

TomCat96 wrote:Is there a reason why staying the course is hard?

Uh, yeah, people do not like to lose money.


Should we assume the vast majority of people are capable of handling 40% drops in the market?

No, we can assume most people cannot handle big markets drops.

If the ability to stay the course is difficult, would that not theoretically open up an avenue for hedge funds to exploit?

It doesn't have to be hedge funds. As you know, retail investors are called the dumb money, and Wall St. just sits and waits for people to sell low, and they are the ones buying. We also have some members here who do the same thing.

For example if markets go up, then the intrinsic greed of people might cause people to jump in. If markets go down, then the intrinsic attribute of people to panic would cause even more people to sell.

Yep.

If such tendencies were exploitable, it seems that one could profit without any special market information at all.
One would be able to outperform the market because of the market inefficiency caused by human nature.

Yes, and people do capitalize on those facts.

Now for the disclaimer -- There have been some behavioral funds created and a few have done well, but most have already closed due to dismal performance. I guess we cannot forget that fund managers and advisors are also subject to behavioral errors.
:oops:

Paul
When times are good, investors tend to forget about risk and focus on opportunity. When times are bad, investors tend to forget about opportunity and focus on risk.

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Re: Beating the market through behavioral finance.

Post by Fallible » Tue Feb 14, 2017 7:54 pm

TomCat96 wrote:...
A behavioral finance strategy cannot profit off one who is resolved to stay the course no matter what. ...
I'm still not certain what you mean by a "behavioral finance strategy" so bear with me. I think you mean manipulation of investors not in sufficient control of their emotions such as fear and greed, or their cognitive biases such as overconfidence, loss aversion, risk aversion, confirmation bias, recency bias, etc. Also, staying the course is also a matter of behavioral control resulting from lessons learned from BF. It's ALL about human behavior, whether the manipulator or the manipulated. But if this is not what you mean by a BF strategy, what do you mean?
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Re: Beating the market through behavioral finance.

Post by AlohaJoe » Tue Feb 14, 2017 8:39 pm

Actually most people DO stay the course. Over 90% of them do. And those who don't stay the course are almost exclusively men.

That was the finding of the 2006 paper "The Inattentive Participant: Portfolio Trading Behavior in 401(k) Plans". The authors were granted access by Fidelity to the trading behavior of 1.2 million people and found that 80% didn't make a single trade in 2 years. Another 11% made a single trade in 2 years.

Those who traded were affluent men. Which, anecdotally, matches my perception of the people who post on Bogleheads about making constant changes.

TomCat96
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Re: Beating the market through behavioral finance.

Post by TomCat96 » Tue Feb 14, 2017 9:02 pm

Fallible wrote:
TomCat96 wrote:...
A behavioral finance strategy cannot profit off one who is resolved to stay the course no matter what. ...
I'm still not certain what you mean by a "behavioral finance strategy" so bear with me. I think you mean manipulation of investors not in sufficient control of their emotions such as fear and greed, or their cognitive biases such as overconfidence, loss aversion, risk aversion, confirmation bias, recency bias, etc. Also, staying the course is also a matter of behavioral control resulting from lessons learned from BF. It's ALL about human behavior, whether the manipulator or the manipulated. But if this is not what you mean by a BF strategy, what do you mean?

Here's an example. Let's assume the market crashes 40%. Both you and I have exactly the same data. Neither of us has superior information to the other one.

Suppose for example's sake one of us will definitely panic. The person who panic sells after the market has crashed 40% will cause the market to dip ever so slightly. Now the person who didn't panic buys in. The person who bought in gets an infinitesimal free lunch.

The market fully accounted for pricing in the companies based on earnings forecasts like a good efficient market should. Suppose the market's security price (ex. VTI) after crashing 40% was $120.00. The market is therefore efficiently priced at $120.00

What the market did not account for was one of us panic selling, causing the dip to drop to $119.98.
That mispricing is an opportunity for profit.

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Re: Beating the market through behavioral finance.

Post by staythecourse » Tue Feb 14, 2017 9:06 pm

TomCat96 wrote:
Sachay wrote:Hedge funds are run by people. Hedge funds returned only 23 percent from 2010 to 2015, compared with 108 percent for the S&P Index. I exploited this in the best way possible- by hardly lifting a finger. Too bad us mere mortals can't short the hedge funds or receive million dollar bonuses for subpar performance.

I didn't mean hedge funds per se, I meant strategically if there is a tendency for people to trade based on human factors, such factors ought to theoretically be exploitable by anyone with sufficient capital and liquidity.
Interestingly, I thought years ago why quants have not made a fund to take advantage of this. Hedge funds are run by people, BUT the don't do the trading. Computers do the trading based on their programming. So wondering why no one has designed a computer systemt to buy when others sell?

Good luck.
"The stock market [fluctuation], therefore, is noise. A giant distraction from the business of investing.” | -Jack Bogle

TomCat96
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Re: Beating the market through behavioral finance.

Post by TomCat96 » Tue Feb 14, 2017 9:08 pm

AlohaJoe wrote:Actually most people DO stay the course. Over 90% of them do. And those who don't stay the course are almost exclusively men.

That was the finding of the 2006 paper "The Inattentive Participant: Portfolio Trading Behavior in 401(k) Plans". The authors were granted access by Fidelity to the trading behavior of 1.2 million people and found that 80% didn't make a single trade in 2 years. Another 11% made a single trade in 2 years.

Those who traded were affluent men. Which, anecdotally, matches my perception of the people who post on Bogleheads about making constant changes.
That is absolutely fascinating. Sometimes people know just enough to be a danger to themselves...

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Re: Beating the market through behavioral finance.

Post by TomCat96 » Tue Feb 14, 2017 9:12 pm

pkcrafter wrote:
TomCat96 wrote:Is there a reason why staying the course is hard?

Uh, yeah, people do not like to lose money.


Should we assume the vast majority of people are capable of handling 40% drops in the market?

No, we can assume most people cannot handle big markets drops.

If the ability to stay the course is difficult, would that not theoretically open up an avenue for hedge funds to exploit?

It doesn't have to be hedge funds. As you know, retail investors are called the dumb money, and Wall St. just sits and waits for people to sell low, and they are the ones buying. We also have some members here who do the same thing.

For example if markets go up, then the intrinsic greed of people might cause people to jump in. If markets go down, then the intrinsic attribute of people to panic would cause even more people to sell.

Yep.

If such tendencies were exploitable, it seems that one could profit without any special market information at all.
One would be able to outperform the market because of the market inefficiency caused by human nature.

Yes, and people do capitalize on those facts.

Now for the disclaimer -- There have been some behavioral funds created and a few have done well, but most have already closed due to dismal performance. I guess we cannot forget that fund managers and advisors are also subject to behavioral errors.
:oops:

Paul
It would be the irony of ironies if behaviorial funds themselves experience severe redemption requests in times of panic, thereby causing their dismal performance.

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Re: Beating the market through behavioral finance.

Post by pkcrafter » Tue Feb 14, 2017 9:17 pm

Tomcat wrote:
It would be the irony of ironies if behaviorial funds themselves experience severe redemption requests in times of panic, thereby causing their dismal performance.
Yessss! :D

Paul
When times are good, investors tend to forget about risk and focus on opportunity. When times are bad, investors tend to forget about opportunity and focus on risk.

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Re: Beating the market through behavioral finance.

Post by avalpert » Tue Feb 14, 2017 9:17 pm

TomCat96 wrote:
Fallible wrote:
TomCat96 wrote:...
A behavioral finance strategy cannot profit off one who is resolved to stay the course no matter what. ...
I'm still not certain what you mean by a "behavioral finance strategy" so bear with me. I think you mean manipulation of investors not in sufficient control of their emotions such as fear and greed, or their cognitive biases such as overconfidence, loss aversion, risk aversion, confirmation bias, recency bias, etc. Also, staying the course is also a matter of behavioral control resulting from lessons learned from BF. It's ALL about human behavior, whether the manipulator or the manipulated. But if this is not what you mean by a BF strategy, what do you mean?

Here's an example. Let's assume the market crashes 40%. Both you and I have exactly the same data. Neither of us has superior information to the other one.

Suppose for example's sake one of us will definitely panic. The person who panic sells after the market has crashed 40% will cause the market to dip ever so slightly. Now the person who didn't panic buys in. The person who bought in gets an infinitesimal free lunch.

The market fully accounted for pricing in the companies based on earnings forecasts like a good efficient market should. Suppose the market's security price (ex. VTI) after crashing 40% was $120.00. The market is therefore efficiently priced at $120.00

What the market did not account for was one of us panic selling, causing the dip to drop to $119.98.
That mispricing is an opportunity for profit.
You seem to be forgetting that not having 'superior information to the other one' includes information on what other market players will do (in fact that is the primary information you lack in beating the market).

There is nothing with enough precision in behavioral finance to predict when the panicking will stop, or when the 'irrational exuberance' will turn around. And, in fact, the research seems to indicate that level of precision is inherently impossible - momentum is a real phenomenon that exists right up until it doesn't.

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Re: Beating the market through behavioral finance.

Post by noraz123 » Wed Feb 15, 2017 12:18 am

livesoft wrote: Also I don't try to beat the market. Instead, I try to beat a benchmark. Big difference.
I am not sure I understand. I assume you are implying that you try to beat the S&P500 or a something similar? If so, do you mind me asking what your strategy is? Is more than investing during "really bad days"?

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Re: Beating the market through behavioral finance.

Post by livesoft » Wed Feb 15, 2017 7:12 am

A benchmark for me is a fund such as VSMGX or VBIAX or VWENX.

The strategy is to have more invested in equities than the benchmark when the market is going up and the same or less invested in equities when the market is not going up and to small-cap and value tilt the equities.

Since a benchmark has no added fees and pays no taxes, my portfolio has no added fees and pays no taxes.
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Re: Beating the market through behavioral finance.

Post by VictoriaF » Wed Feb 15, 2017 8:08 am

People are irrational, and so are markets. “The market can stay irrational longer than you can stay solvent.” (John Maynard Keynes)

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Re: Beating the market through behavioral finance.

Post by gilgamesh » Wed Feb 15, 2017 9:13 am

livesoft wrote:A benchmark for me is a fund such as VSMGX or VBIAX or VWENX.

The strategy is to have more invested in equities than the benchmark when the market is going up and the same or less invested in equities when the market is not going up and to small-cap and value tilt the equities.

Since a benchmark has no added fees and pays no taxes, my portfolio has no added fees and pays no taxes.
How do you define, 'market is going up' and how do you define 'market is not going up'?

How do you decide how much more (the magnitude) or less in equities to hold? Or magnitude of tilt towards or away from small cap and value?

Thanks!

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Re: Beating the market through behavioral finance.

Post by gilgamesh » Wed Feb 15, 2017 9:15 am

AlohaJoe wrote:Actually most people DO stay the course. Over 90% of them do. And those who don't stay the course are almost exclusively men.

That was the finding of the 2006 paper "The Inattentive Participant: Portfolio Trading Behavior in 401(k) Plans". The authors were granted access by Fidelity to the trading behavior of 1.2 million people and found that 80% didn't make a single trade in 2 years. Another 11% made a single trade in 2 years.

Those who traded were affluent men. Which, anecdotally, matches my perception of the people who post on Bogleheads about making constant changes.
Thanks for sharing, very helpful.

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Re: Beating the market through behavioral finance.

Post by gilgamesh » Wed Feb 15, 2017 9:21 am

arcticpineapplecorp. wrote:
TomCat96 wrote:Is there a reason why staying the course is hard?

Should we assume the vast majority of people are capable of handling 40% drops in the market? Or should we assume that we should advise them based on such characteristics being uncommon.

A fund which operates as such would be able to profit not because of superior information, but because of superior ability to execute based on the same static information. Are human tendencies exploitable in investing?
Did you mean to say "should we assume the vast majority of people are INCAPABLE of handling 40% drops in the market"? Because that's what I've come to believe. I don't think there are many who can handle that. And it's not just because of fear (though that is a large reason). I witnessed a 45 year old woman sell all her low cost index stock funds and move money to a stable value fund AFTER the market declined in 2008 despite having at least 20 years until retirement, a recession resistent job (became busier during the recession because of a increase in applicants for benefits), a four-year government contract and the backing of a union. And yet she still sold it all (at the wrong time). And the U.S. market didn't even lose 40% in 2008 (it lost 38% if memory serves. Yes I know that's basically the same thing).

But let us not forget there were many people who had investments in 2008-2009 and had done everything they were told to do prior, as in "keep an emergency fund of 3-6 months" which was conventional wisdom prior to the Great Recession, and only after that were experts telling people to keep a year or more in emergency savings (that would have been helpful before the recession, not after). These fine folks did everything right, but they were out of a job and couldn't get another one for a year or longer. These folks had to raise cash any way they could which meant selling stocks. They may not had wanted to, but they had to in order to keep food on table, roof over head and gas in car.

Finally, regarding your second statement above (about a fund that operates), let's not forget that funds have to meet redemptions. Less redemptions if people don't panic, but in the example I gave above regarding people having to sell out whether they wanted to or not, this resulted in many funds being forced to sell also, whether they wanted to or not. So fund managers aren't at their own whims. They have to work within the limitations they're given, which includes fund outflows, sometimes at the worst possible times.
So, all those predictions based on past market performance didn't help these folks. At least they had human capital left even if they lost their jobs. How about retirees with zero human capital left? Worse correct? Is it wise to rely on predictors based on past performances, like firecalc? It works until it doesn't', right?

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Re: Beating the market through behavioral finance.

Post by gilgamesh » Wed Feb 15, 2017 9:22 am

VictoriaF wrote:People are irrational, and so are markets. “The market can stay irrational longer than you can stay solvent.” (John Maynard Keynes)

Victoria
I've always loved this statement, very appropriate here. Says it all.

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Re: Beating the market through behavioral finance.

Post by staythecourse » Wed Feb 15, 2017 9:27 am

AlohaJoe wrote:Actually most people DO stay the course. Over 90% of them do. And those who don't stay the course are almost exclusively men.

That was the finding of the 2006 paper "The Inattentive Participant: Portfolio Trading Behavior in 401(k) Plans". The authors were granted access by Fidelity to the trading behavior of 1.2 million people and found that 80% didn't make a single trade in 2 years. Another 11% made a single trade in 2 years.

Those who traded were affluent men. Which, anecdotally, matches my perception of the people who post on Bogleheads about making constant changes.
Interesting. I am not so quick to make huge inferences based on that study. It looks at 401k plan only. I don't actively trade, but do folks usually do that out of their retirement accounts or a brokerage account setup with a discount brokerage house? My guess is it is the latter. So the results of the study don't necessarily prove that most folks don't trade excessively since they are missing the most actively traded accounts. How else do you think many of the discount brokerages stay afloat if not for "churning" by their clients? Considering the DALBAR studies have shown the individual investor come far short of the benchmark year after year I am pretty sure that delta is NOT just higher cost funds, but due to some behavioral issues as well.

I would venture to guess most do NOT excessively trade in their 401k as the data supports most folks with a 401k don't even know what they are invested in, i.e. the reason plan administrators developed automatic enrollment into target retirement funds as a default. Comparing the returns of the 401k vs. the smaller discount brokerages probably a good inference that doing nothing is better then doing something. Sounds familiar, doesn't it?

Good luck.
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Re: Beating the market through behavioral finance.

Post by David Jay » Wed Feb 15, 2017 10:25 am

pkcrafter wrote:Tomcat wrote:
It would be the irony of ironies if behaviorial funds themselves experience severe redemption requests in times of panic, thereby causing their dismal performance.
Yessss! :D

Paul
I would propose that this is why you can benefit when trading for your own account but it is difficult in a mutual fund.
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Re: Beating the market through behavioral finance.

Post by livesoft » Wed Feb 15, 2017 11:02 am

gilgamesh wrote:
livesoft wrote:A benchmark for me is a fund such as VSMGX or VBIAX or VWENX.

The strategy is to have more invested in equities than the benchmark when the market is going up and the same or less invested in equities when the market is not going up and to small-cap and value tilt the equities.

Since a benchmark has no added fees and pays no taxes, my portfolio has no added fees and pays no taxes.
How do you define, 'market is going up' and how do you define 'market is not going up'?

How do you decide how much more (the magnitude) or less in equities to hold? Or magnitude of tilt towards or away from small cap and value?

Thanks!
Well, now you are starting to ask about the RBD (Really Bad Day) algorithm. :) There are many threads on this. One cannot predict the future, but one can see the immediate past. For instance, if the market has dropped 4% by 3:30 pm eastern time today, then you are pretty sure that the "market is not going up."

Here is another thread to read: viewtopic.php?t=194427

Furthermore, don't get your hopes up. If one exceeds the performance of their benchmark by 0.000000001%, then it is still beating the benchmark.

As for tilt amounts, please read: viewtopic.php?t=193537
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Re: Beating the market through behavioral finance.

Post by gilgamesh » Wed Feb 15, 2017 11:13 am

livesoft wrote:
gilgamesh wrote:
livesoft wrote:A benchmark for me is a fund such as VSMGX or VBIAX or VWENX.

The strategy is to have more invested in equities than the benchmark when the market is going up and the same or less invested in equities when the market is not going up and to small-cap and value tilt the equities.

Since a benchmark has no added fees and pays no taxes, my portfolio has no added fees and pays no taxes.
How do you define, 'market is going up' and how do you define 'market is not going up'?

How do you decide how much more (the magnitude) or less in equities to hold? Or magnitude of tilt towards or away from small cap and value?

Thanks!
Well, now you are starting to ask about the RBD (Really Bad Day) algorithm. :) There are many threads on this. One cannot predict the future, but one can see the immediate past. For instance, if the market has dropped 4% by 3:30 pm eastern time today, then you are pretty sure that the "market is not going up."

Here is another thread to read: viewtopic.php?t=194427

Furthermore, don't get your hopes up. If one exceeds the performance of their benchmark by 0.000000001%, then it is still beating the benchmark.

As for tilt amounts, please read: viewtopic.php?t=193537
OH yeah! Up you've shared that before, ... My head is not working properly today.

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Re: Beating the market through behavioral finance.

Post by TomCat96 » Wed Feb 15, 2017 11:17 am

avalpert wrote:
TomCat96 wrote:
Fallible wrote:
TomCat96 wrote:...
A behavioral finance strategy cannot profit off one who is resolved to stay the course no matter what. ...
I'm still not certain what you mean by a "behavioral finance strategy" so bear with me. I think you mean manipulation of investors not in sufficient control of their emotions such as fear and greed, or their cognitive biases such as overconfidence, loss aversion, risk aversion, confirmation bias, recency bias, etc. Also, staying the course is also a matter of behavioral control resulting from lessons learned from BF. It's ALL about human behavior, whether the manipulator or the manipulated. But if this is not what you mean by a BF strategy, what do you mean?

Here's an example. Let's assume the market crashes 40%. Both you and I have exactly the same data. Neither of us has superior information to the other one.

Suppose for example's sake one of us will definitely panic. The person who panic sells after the market has crashed 40% will cause the market to dip ever so slightly. Now the person who didn't panic buys in. The person who bought in gets an infinitesimal free lunch.

The market fully accounted for pricing in the companies based on earnings forecasts like a good efficient market should. Suppose the market's security price (ex. VTI) after crashing 40% was $120.00. The market is therefore efficiently priced at $120.00

What the market did not account for was one of us panic selling, causing the dip to drop to $119.98.
That mispricing is an opportunity for profit.
You seem to be forgetting that not having 'superior information to the other one' includes information on what other market players will do (in fact that is the primary information you lack in beating the market).

There is nothing with enough precision in behavioral finance to predict when the panicking will stop, or when the 'irrational exuberance' will turn around. And, in fact, the research seems to indicate that level of precision is inherently impossible - momentum is a real phenomenon that exists right up until it doesn't.

True. You could argue that one party in this case did in fact have superior information. He knew the other guy would panic.
But the reason I included that in here is because that's the point we are trying to decide.

Is the knowledge that the other guy going to panic "information" the market should take into account?

Can one beat the market by studying the behavior of people? Is the behavior of people consistent enough as a market force that those with (market information) are at a disadvantage to the person with (market information + behavioral finance tendencies)

If the answer is yes, then eventually, behavior will should become a part of the body of information markets take into account, even after all public knowledge concerning a company's future earnings.

But the answer may well be no. It could be the case that peoples' behavior is not consistent or unidirectional enough to allow one sufficient advantage to beat the market.


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Re: Beating the market through behavioral finance.

Post by kolea » Wed Feb 15, 2017 11:27 am

Why do I need to beat the market? What happened to just meeting the goals set out in my investment plan? If I make 2-3% real return over the next 25 years or so (which is about my life expectancy) I will be thrilled to death, literally. :)
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Re: Beating the market through behavioral finance.

Post by ThisTimeItsDifferent » Wed Feb 15, 2017 12:12 pm

Also, "the markets can stay irrational longer than you can stay solvent."

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Re: Beating the market through behavioral finance.

Post by VictoriaF » Wed Feb 15, 2017 12:20 pm

ThisTimeItsDifferent wrote:Also, "the markets can stay irrational longer than you can stay solvent."
As Keynes and I said earlier.

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Re: Beating the market through behavioral finance.

Post by Fallible » Wed Feb 15, 2017 12:43 pm

TomCat96 wrote:
avalpert wrote:
TomCat96 wrote:
Fallible wrote:
TomCat96 wrote:...
A behavioral finance strategy cannot profit off one who is resolved to stay the course no matter what. ...
I'm still not certain what you mean by a "behavioral finance strategy" so bear with me. I think you mean manipulation of investors not in sufficient control of their emotions such as fear and greed, or their cognitive biases such as overconfidence, loss aversion, risk aversion, confirmation bias, recency bias, etc. Also, staying the course is also a matter of behavioral control resulting from lessons learned from BF. It's ALL about human behavior, whether the manipulator or the manipulated. But if this is not what you mean by a BF strategy, what do you mean?

Here's an example. Let's assume the market crashes 40%. Both you and I have exactly the same data. Neither of us has superior information to the other one.

Suppose for example's sake one of us will definitely panic. The person who panic sells after the market has crashed 40% will cause the market to dip ever so slightly. Now the person who didn't panic buys in. The person who bought in gets an infinitesimal free lunch.

The market fully accounted for pricing in the companies based on earnings forecasts like a good efficient market should. Suppose the market's security price (ex. VTI) after crashing 40% was $120.00. The market is therefore efficiently priced at $120.00

What the market did not account for was one of us panic selling, causing the dip to drop to $119.98.
That mispricing is an opportunity for profit.
You seem to be forgetting that not having 'superior information to the other one' includes information on what other market players will do (in fact that is the primary information you lack in beating the market).

There is nothing with enough precision in behavioral finance to predict when the panicking will stop, or when the 'irrational exuberance' will turn around. And, in fact, the research seems to indicate that level of precision is inherently impossible - momentum is a real phenomenon that exists right up until it doesn't.

True. You could argue that one party in this case did in fact have superior information. He knew the other guy would panic.
But the reason I included that in here is because that's the point we are trying to decide.

Is the knowledge that the other guy going to panic "information" the market should take into account?

Can one beat the market by studying the behavior of people? Is the behavior of people consistent enough as a market force that those with (market information) are at a disadvantage to the person with (market information + behavioral finance tendencies)

If the answer is yes, then eventually, behavior will should become a part of the body of information markets take into account, even after all public knowledge concerning a company's future earnings.

But the answer may well be no. It could be the case that peoples' behavior is not consistent or unidirectional enough to allow one sufficient advantage to beat the market
.
What you are saying/asking is not new, i.e., using BF in investing. This 2010 article from Institutional Investor may be of interest. Here's a graf from it, followed by the link:
Over the past 15 years, there has been a steady increase in the number of fund managers that are using behavioral finance concepts to select stocks and construct portfolios. One estimate is that half of the 200 listed small-cap value funds use some form of behavioral finance in selecting their portfolios. Such firms as Fuller & Thaler, Chicago-based LSV Asset Management and even fund behemoth J.P. Morgan Asset Management have deployed strategies that use behavioral concepts to select equities for their portfolios. And all of them are beating their market benchmarks over the long term.
http://www.institutionalinvestor.com/Ar ... stors.html
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Re: Beating the market through behavioral finance.

Post by boglephreak » Wed Feb 15, 2017 12:49 pm

TomCat96 wrote:Is there a reason why staying the course is hard?
for me personally, reading boglehead threads on small cap value, factors, etc. causes me to constantly want to tweak my portfolio. i am less than a year in to the boglehead approach though so havent really hit the point where i am 100% confident in my current portfolio to contribute and stay the course. currently in a three-fund portfolio, which i am 95% confident in, but should i tilt......?

i can imagine how people who dont know about the boglehead approach feel when they see the big-heads on tv/radio/etc. promoting new get-rich quick schemes (especially if the previous schemes arent working out for them at the time). people are very persuasive and THEY HAVE CHARTS!

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Re: Beating the market through behavioral finance.

Post by livesoft » Wed Feb 15, 2017 1:16 pm

boglephreak wrote:i can imagine how people who dont know about the boglehead approach feel when they see the big-heads on tv/radio/etc. promoting new get-rich quick schemes (especially if the previous schemes arent working out for them at the time). people are very persuasive and THEY HAVE CHARTS!
That's why I liked this 4-part video series: viewtopic.php?t=205911

One take-away is that even if you do everything right, you may be one of the ones who trails the benchmarks. I suggest you watch the videos. Warning: There are CHARTS!
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Re: Beating the market through behavioral finance.

Post by David Jay » Wed Feb 15, 2017 1:25 pm

boglephreak wrote:
TomCat96 wrote:Is there a reason why staying the course is hard?
for me personally, reading boglehead threads on small cap value, factors, etc. causes me to constantly want to tweak my portfolio. i am less than a year in to the boglehead approach though so havent really hit the point where i am 100% confident in my current portfolio to contribute and stay the course. currently in a three-fund portfolio, which i am 95% confident in, but should i tilt......?
You are getting very close to the truth, grasshopper.

You have to believe in your asset allocation enough to convince yourself to stay the course when the storms come. If you are not confident in a tilt, don't do it.
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Re: Beating the market through behavioral finance.

Post by inbox788 » Wed Feb 15, 2017 1:43 pm

TomCat96 wrote:If the ability to stay the course is difficult, would that not theoretically open up an avenue for hedge funds to exploit?
For example if markets go up, then the intrinsic greed of people might cause people to jump in. If markets go down, then the intrinsic attribute of people to panic would cause even more people to sell.

If such tendencies were exploitable, it seems that one could profit without any special market information at all.
One would be able to outperform the market because of the market inefficiency caused by human nature.

A fund which operates as such would be able to profit not because of superior information, but because of superior ability to execute based on the same static information. Are human tendencies exploitable in investing?
What makes you think this isn't already being done? There are already players in the marketplace using this strategy explicitly and implicitly (contrarian traders). Ultimately, they're competing with each other and simply having superior information is insufficient. To win the game your superior information and ability has to be not only better than the marketplace, but also beat the next best player.

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Re: Beating the market through behavioral finance.

Post by PVW » Wed Feb 15, 2017 1:56 pm

TomCat96 wrote:Is there a reason why staying the course is hard?

Should we assume the vast majority of people are capable of handling 40% drops in the market? Or should we assume that we should advise them based on such characteristics being uncommon.

If the ability to stay the course is difficult, would that not theoretically open up an avenue for hedge funds to exploit?
For example if markets go up, then the intrinsic greed of people might cause people to jump in. If markets go down, then the intrinsic attribute of people to panic would cause even more people to sell.

If such tendencies were exploitable, it seems that one could profit without any special market information at all.
One would be able to outperform the market because of the market inefficiency caused by human nature.

A fund which operates as such would be able to profit not because of superior information, but because of superior ability to execute based on the same static information. Are human tendencies exploitable in investing?
The average tendency of emotional investing is to follow the herd and this tends to reinforce the market direction. You can exploit this tendency by following the herd. You probably cannot exploit this tendency by predicting when the herd will turn.

https://en.wikipedia.org/wiki/Momentum_investing

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Re: Beating the market through behavioral finance.

Post by AlohaJoe » Thu Feb 16, 2017 2:04 am

staythecourse wrote:Considering the DALBAR studies have shown the individual investor come far short of the benchmark year after year I am pretty sure that delta is NOT just higher cost funds, but due to some behavioral issues as well.
The DALBAR studies are misleading and likely wrong.

In 2004 Jonathan Clements pointed out that DALBAR had been doing calculations wrong for over a decade, resulting in them overstating the performance gaps by nearly triple: https://www.wsj.com/articles/SB108068334292269415

Many others have pointed out that the performance gap isn't necessarily caused by people being dumb or irrational but simply due to the timing of when they have cash (i.e. when they get paid): http://www.highviewfin.com/blog/does-da ... r-returns/

And some are even more critical of DALBAR's methodology (and results): https://www.advisorperspectives.com/art ... ng-results
DALBAR measures investor returns in one way and measures mutual fund returns in another way. The measure of investor returns is meant to take into account the timing of their cash flows, while the measure of mutual fund returns doesn’t.
tfb (who posts here) is another who isn't a fan of DALBAR: https://www.kitces.com/blog/does-the-da ... uest-post/
even the DALBAR study shows that if an investor had simply “invested a fixed amount in equity funds every year, the investor return would have been 3.17% a year for 20 years, compared to the actual investor return of 3.49% a year.” In other words, the average investor beat an investor who merely invested a fixed amount every year.
There is no question that there are large numbers of investors who shoot themselves in the foot with behavioural trading mistakes. But I don't think it is clear at all that those people make up the majority, much less the overwhelming majority, of investors.

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Re: Beating the market through behavioral finance.

Post by dave_k » Thu Feb 16, 2017 12:41 pm

What makes you think that the anticipation of panic selling (or buying into an overheated market) isn't already priced in under conditions where that may be expected? It may not be priced in exactly, but how would you know if it was over or underestimated?

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